Sunday, March 09, 2008

Rising Inflation Expectations: Bad News or Good News?

Suppose that Greg Mankiw and others are correct in suggesting that inflation expectations have risen dramatically. Is this bad news or good news?

By way of full disclosure, I should note that it’s clearly good news for me, since I’m short nominal Treasury notes. If you follow the logic, that means it’s in my interest to convince other investors that conditions are more inflationary than I really think they are, so while the main point of my last post still stands, you should probably take the caveats (“There's little question that the expected inflation rate has risen...”) with a grain of salt. (Rising inflation expectations are clearly good news for me, but if this is what the good news looks like, I’d hate to see what happens to nominal yields when inflation expectations are falling!)

As to the “general interest,” however, the most obvious interpretation is that rising inflation expectations are bad news, because they mean that markets have lost confidence in the Fed’s willingness to keep inflation within its perceived target range. Or, as Greg puts it (quoting the Cleveland Fed’s Web server and adding a double entendre), “the system ‘has experienced an unexpected error.’” If the market loses confidence in the Fed’s inflation target, then, theoretically, the change in the expectations term in the Phillips curve causes it to shift upward, and we can anticipate both higher unemployment rates (in the short run) and higher inflation rates (in both the short run and the long run, unless confidence is eventually restored) than we would otherwise experience at any given level of aggregate demand.

Under that interpretation, the higher unemployment rates in the short run are clearly bad news. As for the higher inflation rates, I’m not so sure. A slightly different, but related, interpretation is that the market correctly perceives that the Fed has finally come to its senses and raised its inflation target from an unreasonably low level. Indeed, the current crisis, in which reasonable people are worried both about inflation becoming unhinged and about a potential deflationary collapse, is a good demonstration of why the target should be higher. It is kind of hard to believe that the Fed has come to its senses, though, since the rest of the world’s major central banks have been even further from their senses than the Fed.

Even if you think the Fed’s perceived* inflation target (between 1.75% and 2% on the personal consumption deflator, which is maybe about 2.25% to 2.5% on the CPI) is reasonable, you might think there are certain situations where the target should be raised. One of those situations might be a “safety trap” – where investors shun all but ultra-safe assets, even when the expected returns become much lower than those on risky assets. Arguably (though the argument becomes much weaker when you look at the stock market instead of the credit markets) the US is experiencing a safety trap now, and one solution is to take away the safety of the supposed safe asset by promising to inflate away the returns to be earned by government bondholders. Another situation where raising the target might be a good idea is when the uncertainty around the expected inflation rate increases, so that pursuing the original target would produce a significant risk of deflation. There might be a fairly strong case (as I suggest in the previous paragraph) that the US is in that situation right now. Obviously if you think that current circumstances call for an increase in the inflation target, then it is good news to learn that (in the judgment of the market) the target has actually increased.

But all these interpretations assume that the general shape of the distribution of inflation possibilities remains roughly the same. Moreover, casual talk of “expected inflation” suggests that we think the mean and the median of the distribution are roughly the same, since “expected inflation” could refer to either one. But perhaps what has happened is that the mean of the distribution has risen but the median has not. I would interpret the Fed’s target more as a median than as a mean. I would certainly hope that it isn’t the mean, and that the Fed would be more willing to tolerate inflation rates 3% above its target (high by recent standards but far from disastrous) than rates 3% below its target (deflation, which could be disastrous). Under this interpretation, the market still has confidence in the Fed’s target as a median, but the market is reassured that extremely low inflation rates will not be tolerated, so that the distribution has become more skewed to the right, and the mean has risen. In that case, the increase in mean (but not median) inflation expectations is good news.

[UPDATE: Paul Krugman, using what seems to be another species of the "in this situation, the inflation target should be raised" argument, makes the case that high inflation expectations are good news.]

*The Fed has actually announced a 3-year-ahead forecast, which can perhaps be reasonably interpreted as a target.

43 Comments:

I am continuously struck by what seems to be an inordinate obsession with inflation.

I tend to think of myself as a hawk, but when we are facing potential financial meltdown and a crisis that seems to bear a striking resemblance to Japan in 1989/90, I hardly think a 60-70 bps increase in headline inflation expectations is something to get all in a huff about.

Not to mention I am not 100% convinced that I am not looking at an increase in liquidity premiums for T-Notes.

But seriously 70bps to prevent a Japanese style depression, I would gladly take 500bps and not lose a moment of sleep over it.

The thing I don't get about the comparison with Japan (which I hear frequently) is that, as far as I can see, Japan had plenty of missed opportunities in the early to mid 90s to prevent the depression from getting out of hand. It was only when the inflation rate went to zero (and subsequently negative) that it really became intractable. You're saying we have to nip it in the bud and it should take priority over all other concerns. I don't see why. Why shouldn't the Fed pursue "reasonable price stability" (whatever that means) until we actually observe the low inflation rates that signal a real danger that policy could become ineffective if they are allowed to go much lower. As long as the inflation rate is above 3%, we can afford to put off the aggressive monetary stimulus until next year or the year after.

The other problem with the Japan analogy is the exchange rate. I'd say there is already a lot of stimulus in the pipeline from the weak dollar. In Japan's case, it was just the opposite. In fact, I would regard the strong yen of the early 90s (as I recall it got down below 80 to the dollar at one point) as an index of policy failure. For the US today, the analogous index seems to be saying that the Fed is doing quite enough.

First, is that a rapid deceleration in world growth could lead to a sudden collapse in inflation.

Unit labor costs do not seem to be out of control. Much of the inflation is comming through commodity prices. It is at least a concern that commodity prices could begin to fall if global growth falters.

Second, my hunch is that the dollar will make up much of it lost value when Central Banks aroudn the world begin to cut to fight contagion. Even if they resist cutting the drop in equity prices around the world could spur the dollar.

Not only is a rising dollar deflationary but it could choke of net exports as a support.

Add, to this my concern that debt deflation and financial meltdown could lead to a prolonged decline in consumption and I think you set up at least the possibility for a deflationary spiral.

So the risks are there. The consquences are dire, not only for the US but the ROW as well.

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